Economics 101 Is Messing Up Your Pricing! Here’s why..
The influence that a certain business economics 101 chart still has on most business executives’ view of price and revenue management is huge. Can you guess the one I mean?
You got it: This one (below).
Take a look at this price-volume chart for a moment:
It basically sums up what most executives and leaders know about pricing?
And, because of this chart, most sales directors believe that price and volume are always correlated; and that increasing prices, leads to less sales, lost volume and few new business opportunities.
Similarly, because of this chart, many finance directors believe that increasing all prices by 3% is a great idea to instantly increase profit when in fact it can be a terrible idea and a highly disruptive action in the market.
What do you think is the problem with these assumptions?
.Answer–I: the line on this chart is not fixed and can move on an SKU by SKU and segment by segment basis.
Answer–II: A broad-brush approach to pricing is risky and can lose your hard-earned margin, volume and customers.
Answer–III: that this economic 101 chart is an incomplete view of price profit elasticity and delaying price innovation in B2B businesses.
Why is business economics 101 not always true in the real world?
To explain this further:
This pricing and business economics 101 chart is the root cause for your post price rise pain. Things like:
- Issuing credit notes straight after a price increase.
- Offering excessive discounts to win and maintain business.
- Cringing at the price exceptions report and large spread of special pricing arrangements.
In the real world of business economics, price and volume are not always correlated. Even though we have been taught otherwise at university.
If you don’t believe me, look around you: There are many instances of highly-priced products that also have market dominance and yes, even in B2B commodity businesses and industry.
For example, certain fuels lubricants, cooking oils, timber, adhesives, chemical surfactants, agriblends – are all commodity products; all have strong market dominance, and all have high relative prices.
On an SKU by SKU basis, the price-volume chart that we all know does not always translate, and the line actually moves.
A belief that the line never moves has become a latent rule in our brains and one which is positively reinforced during pricing and business economic studies at university.
Applying this rule across individual SKUs and product categories are incomplete and leads to margin loss.
Why does the line move?
Value is often relative, intangible and dependent on the buyer. It is a dynamic concept and it’s the job of a pricing team to continually search, identify and capture value to secure low-risk price premiums – kind of like picking up lots of $50 dollars notes off the floor.
A good pricing team never sets a price and then forgets about it for months– that’s it, my job is done, let’s see the money rolling in. It doesn’t work that way…rather, a pricing team battles daily to disprove this business economics 101 chart to generate more revenue and margin for the business.
Even if a pricing team thinks they’ve identified value, a pricing environment can and often does change. This is why the line on the chart moves, and a pricing team needs to constantly think where it is and where it’ll be in 6-9 months.
A good pricing team is never complacent; they continually test and learn from focused and tactical price actions using the scientific process and a range of price methodology.
A good pricing team is always on the lookout for discovering sources of value and understanding how the market responds to price and perceives value.
They seek to capture additional price premiums whether this is in the product itself or in the supply chain, network effect or community.
A pricing team is unlike a sales and finance team because it seeks to quantify intrinsic value and monetise intangible value to boost revenue and margin. This is a quantum leap from simple cost-plus pricing – you don’t need a pricing team for that.
Great pricing teams challenges conventional and ingrained and often incomplete views on business and business:
- You don’t need a pricing team to just sign off and manage discounts and administer markups.
- Excessive price reduction to push volume is not the answer to profitable growth
- Your pricing team should be advised that dropping your list price by 7% so your distributors are happy, does not really make them happy it just lowers the bar for the everyone else and encourages price wars
- And your pricing team would never just increase customer prices by 3% across the board to cover output costs because their profitability analysis said this was a good idea.
A good pricing team will dispel myths, rumours about the market and competition; test assumptions and give you viable pricing options – and explain the trade-offs you’ll end up making with every go to market action.
In very simple terms, you need to break old habits and ways of thinking about price and volume otherwise you risk overcharging some customers and undercharging other customers.
Business Economics 101 is not really inaccurate it’s incomplete and can expose your business to risk.
It neither tells the full story about your pricing power nor informs you of the risk of margin erosion when you use price incorrectly.
Conventional business knowledge based on well-known economic principles may be widespread, but that doesn’t mean they’re always effective and applicable to set and manage price and revenue.
In many instances, the opposite is true: economics 101 is outdated, harmful, and a hindrance to pricing innovation and profitability.
Disruption in your industry is rift; new trends happen. What customers perceive as valuable this year may vary.
Even if you developed a new segmentation last year and painstakingly assigned customers it will always feel like a work in progress because the market changes.
Life is not a simple price volume chart.
In business, price and value are correlated, dynamic and leading indicators of profitability.
The role of the pricing management team is to complete this picture for the business so that they can make more informed pricing decisions and drive sustainable growth and profitability in the process.
But of course, taking a price increase is never as simple as the price volume chart makes out: It takes pricing competence, and know-how to sort through the huge amounts of transactional data and then analyse this data to optimise prices across thousands of products, customers and segments – to be more exact it takes an expert pricing team.
A key role for a pricing management function, therefore, is to challenge traditional economic principles every single day to ensure you capture the full price and value of your offer no matter the situation.
See our recent blog on business model innovation (with a twist!).